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One of the most critical (and often overlooked) pieces of advice for founders is this: Think very carefully before taking any round of funding. And no, the primary concern isn’t dilution. The real issue? Funding closes off exit opportunities.

Wait, what? Isn’t an investment supposed to help you build a more valuable company, making it more attractive for an exit? Yes—but it also drastically increases the price tag on your company, which shrinks the pool of potential buyers.

The Economics of Higher Valuations

Investors aren’t in the business of breaking even. They expect a return, and their expectations set a “floor” for acceptable exit outcomes. Most professional investors aim for a 5X to 10X return on their investment. More importantly, they often have legal stock preferences that allow them to block exits that don’t meet their expectations.

At the same time, they have an anchor for how much of your company they want to own—typically 20% to 30% per round. Let’s work through some quick math based on midpoint values of these expectations:

• Investors want to own 25% of your company.
• That means the post-money valuation of your round will be 1.33X your current value.
• Investors want a 7.5X return, so the required exit price becomes 10X your current value.

Every round of funding you take raises your required exit price by an order of magnitude.

The Exit Math in Action

Let’s put this into perspective:

• Seed Round: Suppose you raise a seed round at a $3M pre-money valuation. Now, to hit a 10X investor return, you need at least a $30M exit. Doable.
• Series A: You raise at a $10M pre-money valuation. Your new required exit price jumps to $100M. That’s a steep climb.
• Series B: Now you’re raising at $25M pre-money, pushing your required exit to $250M. How many companies exit at this level annually? Only about 50 to 100.

And yet, each year, there are roughly 1,000 early-stage VC investments competing for those exits. The odds? Not great.

The Series A Cliff (and Beyond)

There’s a well-documented drop-off in exit opportunities at Series A and beyond. Every round you take exponentially reduces the number of viable buyers, making an acquisition increasingly difficult. Founders should weigh this reality carefully: is the progress you’ll make with additional funding worth the dramatically narrower exit path?

Funding isn’t inherently bad, but it fundamentally changes your trajectory. Before you take that next round, ask yourself: Are you truly ready for the stakes to go up?

This blog post was originally published on 07/02/2013 and last updated on 12/14/25.

It used to take millions in funding to build a tech startup. Before cloud computing and open-source software, launching a product required expensive hardware, in-house servers, large engineering teams, and significant capital just to reach early milestones. Because of these high costs, venture capital firms primarily funded startups at the Series A stage, when companies needed large investments to scale.

Over the past two decades, however, the cost of building a startup has plummeted. Cloud infrastructure eliminated the need for expensive servers. Open-source software reduced development expenses. Low-cost distribution channels made it easier than ever for startups to access customers. As a result, early-stage investing has evolved, giving rise to new funding stages—first Seed, then Pre-Seed, and now Pre-VC—each emerging as the capital required to launch a company decreased.

For investors, this shift presents a compelling opportunity. While traditional VCs continue to focus on larger deals, many early-stage companies are raising smaller rounds well below the investment minimums of traditional institutional venture capital. The result is a funding gap—the Pre-VC stage—that remains largely overlooked by institutional investors, creating an open playing field for those who recognize its potential.

How Early-Stage Investing Evolved

From Series A to Seed: The First Shift (2000-2010)

Before the 2000s, Series A was the starting point for venture capital, with round sizes typically ranging from $3 million to $10 million. Startups at this stage were often pre-revenue, and investors focused on market size, the strength of the founding team, and long-term growth potential rather than financial performance. Funding rounds below $3 million were often limited to angel investors, friends & family, and bootstrapping.

As technology became more capital-efficient, startups needed less money to build and launch products. This shift led to the rise of Seed rounds. By the mid-2000s, dedicated Seed-stage VC firms formalized Seed investing, with round sizes typically between $1 million and $3 million, making Seed a critical bridge to Series A.

The Rise of Pre-Seed: The Next Gap (2010-2020)

As costs continued to decline, some startups needed even less capital before raising a Seed round, which led to an explosion of Micro-VC funds and the emergence of Pre-Seed funding, with rounds typically ranging from $750,000 to $3 million, a space that had formerly been the sole domain of angel investors, friends & family, and accelerators. However, as more founders sought early capital, Pre-Seed investing became more structured. Also, the introduction of the SAFE note by Y Combinator in 2013 played a major role in standardizing these early rounds, making it easier for startups to raise funds without the complexities of traditional equity financing.

Much like Seed rounds a decade earlier, Pre-Seed investing grew over time. Traditional VCs were initially hesitant to participate due to the small check sizes and the labor-intensive nature of early-stage investing. But as startup funding continued to evolve, Pre-Seed rounds became more popular, and many institutional investors now actively participate in this stage.

The Emergence of Pre-VC Investing

Just as Seed investing institutionalized in the 2000s and Pre-Seed evolved in the 2010s, a new funding gap has emerged between angel rounds and institutional VC: Pre-VC investing.

Today’s institutional venture capital firms typically avoid participating in rounds below $1 million, leaving many early-stage startups reliant on friends & family, angel investors, or their own resources. If this story sounds familiar, it’s because it is. In the 2000s, Seed investing was considered too early for institutional venture capital—until it wasn’t. In the 2010s, Pre-Seed investing was dismissed as too small—until it wasn’t. Now, Pre-VC faces the same skepticism from traditional investors, even as it quietly grows.

While large VC firms hesitate, this emerging stage presents an opportunity for investors willing to adapt. Just as institutional investors once overlooked Seed and Pre-Seed, they are now bypassing Pre-VC. This stage represents a market inefficiency, one that investors can leverage by building diversified portfolios of high-potential early-stage startups.

Why Pre-VC Hasn’t Caught On with Most Institutional Investors

Traditional venture capital firms aren’t ignoring Pre-VC because it lacks potential. Instead, structural challenges within their investment models make it difficult for them to participate effectively.

One challenge is that early-stage investing is labor-intensive. Most traditional VC firms pride themselves on using their subjective expertise to pick winners. They evaluate thousands of pitches annually and conduct extensive due diligence before making an investment. The hands-on nature of their involvement makes it difficult to justify small investments.

Another challenge is portfolio construction math. A traditional $100 million venture fund might invest in 25 companies, with an average of $4 million per company. Smaller investments don’t make economic sense for most VCs because they require just as much time and effort as larger deals while contributing little to overall fund returns. A $250,000 Pre-VC check, for example, is too small to justify the labor involved and too insignificant to meaningfully impact the fund’s performance.

For large institutional VC firms, Pre-VC investing simply doesn’t fit their model.

Why Pre-VC Is a Significant Opportunity for Investors

The Pre-VC stage is attractive to investors for two key reasons: capital efficiency and competitive valuations.

Startups at this stage tend to be exceptionally capital-efficient, benefitting both founders and investors. Highly capital-efficient startups have less reliance on external funding which means greater resilience during bad funding markets, like what we’ve seen over the last couple of years. This can mean less dilution risk and higher potential return on investment. Capital-efficient companies can also pivot faster and adapt to market changes.

Many companies at this stage reach profitability early, which means Pre-VC isn’t just their first funding round—it could be their only funding round. Investors at this stage have the rare opportunity to buy meaningful ownership in startups that may never need to raise additional capital.

In addition to capital efficiency, valuations at the Pre-VC stage remain highly attractive. While valuations at all VC stages have soared in recent years, Pre-VC valuations have remained relatively flat. As an example, between 2014 and 2024, Seed valuations rose by 183% according to Pitchbook. In contrast, valuations for Pre-VC investments at Right Side Capital Management (RSCM) increased by only 10% during that same period. This is all a function of supply and demand of capital. During the past decade, especially before 2022, thousands of new VC firms were created, and the VC industry raised tremendous amounts of capital, leading to ever-increasing valuations.  But at the Pre-VC stage, demand has risen every year from founders but very few institutions address this demand, keeping valuations depressed.

Since 2012, RSCM has invested in over 2,000 startups, specifically targeting this funding gap. By streamlining the investment process and challenging traditional VC norms, RSCM has been able to exploit the inefficiencies at this stage and invest in promising early-stage companies at significantly discounted valuations.

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Pre-VC Funding: Investing in the Future Before the Herd Arrives

Early-stage venture funding has always evolved. Seed rounds were once an informal and overlooked segment of investing until they became institutionalized. Pre-Seed rounds followed a similar trajectory, initially dismissed as too small before maturing into a widely accepted funding stage. Now, Pre-VC is emerging as the next logical step in the evolution of early-stage investing.

This funding gap exists not because startups don’t need capital, but because traditional investors aren’t structured to provide it. For those who recognize this shift, Pre-VC represents a rare and valuable market inefficiency.

• The cost of building a startup has never been lower.
• Institutional VCs are ignoring this stage.
• Valuations remain competitive.

As the venture capital landscape continues to evolve, investors who recognize this shift now will find themselves ahead of the herd—investing in the future before the rest of the industry catches up.

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Have you ever finished a challenging task and thought, I went about that all wrong—why didn’t anyone warn me? If you’re gearing up to raise a seed round, consider this your warning.

When faced with a challenge, most entrepreneurs seek out as much data as possible, then dive in. For fundraising, that often means scouring TechCrunch, listening to founder stories, and analyzing top VC blogs. But these sources are inherently biased—only the most unusual cases make the headlines. If you optimize for the outlier, you’ll struggle with the typical case.

At RSCM, we've observed or participated in hundreds of rounds over the last decade. We know what the typical seed raise looks like—and how to navigate it successfully.

The Two Most Common Mistakes: Too Much Money & Fixating on a Lead Investor

The biggest fundraising mistakes we see are:

1. Setting a target raise that’s too high.
2. Getting anchored on the idea of securing a "lead" investor.

Raising a seed round is rarely easy. But the difficulty increases dramatically when moving from a $500K target to $1M+. At that stage, you usually need significant revenue, a well-known founding team, or truly breakthrough technology. While it’s possible to find investors who fall in love with your idea, the odds are low, and the effort required is high.

Even if you meet these extreme criteria, raising $1M+ often requires a lead investor. You might think, That’s fine, I want a lead! But consider this analogy: If you’re an engineer, would you design an architecture with a single point of failure? In marketing, would you create a campaign targeting the lowest-converting users? In sales, would you prioritize prospects with the longest sales cycles? Probably not—yet that's effectively what founders do when structuring a round around a lead from the outset.

If you don’t secure a lead, you could end up with nothing. The universe of lead investors is smaller, they take longer to engage, and closing them is a lengthy process. This delays fundraising and distracts from building your business. Unless your company has at least $20K in monthly revenue, a dozen professional investors already interested, or an absolute need for a large capital infusion, this approach is suboptimal.

A More Effective Strategy: Modest Raise, Brick-by-Brick, Graduated Pricing

If you have little revenue and a limited investor network, start with a modest raise—$250K to $500K. Ensure your plan demonstrates clear progress with this amount and that your cash burn aligns with reasonable milestones.

Step 1: Secure Initial Commitments

Begin with your strongest supporters—friends, advisors, early customers. Many founders hesitate to ask for small checks, thinking it won’t move the needle. But at the start of a raise, momentum is more important than amount.

Offer attractive terms to incentivize quick commitments. A convertible note with a 20% discount, 5% interest, and a compelling cap is a good starting point. A lower cap at the beginning rewards early investors for moving quickly.

Step 2: Raise the Cap Gradually

Once you’ve secured $100K–$200K, bump the cap up. The “great deal” becomes a “good deal.” The increase should reflect investor demand—if early commitments came quickly, raise the cap two notches; if it took longer, only one.

Continue creating urgency. Tie limited-time offers to natural deadlines, such as an accelerator Demo Day, a major product release, or a customer launch. Investors respond to scarcity—use it.

Step 3: Build Toward an Optional Upgrade

Once you’ve closed 50% of your target, you gain leverage. You now have money in the bank, customer traction, and reduced risk. At this stage, you can:

1. Tap into bigger geographies. If you’re outside SF or NYC, start pitching investors in those markets.
2. Leverage platforms like AngelList. A strong lead can attract syndicate funding.
3. Approach small funds that lead rounds. With momentum, you can explore a larger raise.

Sidebar: Process Matters

Fundraising requires structure. Track your prospects in a CRM or spreadsheet. Categorize investors into:

• First check: Early believers who can move quickly.
• Second check: Investors who follow others’ lead.
• Later check: Those who need more traction before committing.
• Lead investors: Professional funds who might anchor the round.

Initially, focus on first and second-check investors. Ask them for referrals to expand your pipeline. Engage with later-check and lead investors early but don’t prioritize closing them until you’ve built momentum.

Oversubscribing, Securing a Lead, and Converting if Necessary

If demand is strong, you may be in a position to upgrade your raise. There are two paths:

1. Oversubscribe: If interest exceeds your target, tell investors you’re at capacity and need firm commitments. Use scarcity to drive action.
2. Entertain a Lead Investor: If a fund expresses interest in leading, push for a term sheet within 7–10 days. Avoid holding out so long that you lose other investors.

Most institutional investors are comfortable leading a seed round with a convertible note. If you’ve already raised via notes and a fund insists on a priced round, don’t worry—you can always convert the notes into equity.

Final Thoughts

It’s easy to adjust when things go better than expected. Plan for the typical case, not the outlier.

Depending on market conditions, only 10-20% of seed rounds have a true lead, and another 10-20% are oversubscribed. That means 60-80% of rounds follow the standard path: a gradual raise without a formal lead. And that’s completely fine.

Fundraising is difficult. Raising $250K to $500K gives you roughly a year of runway. And we’ve seen firsthand how much founders can achieve in a year. Focus on building, execute strategically, and the capital will follow.

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This blog post was originally published on 07/18/2016 and was last updated on March 12, 2025.

Michael Lewis’s Moneyball tells the story of how the Oakland A’s, led by general manager Billy Beane, used statistical analysis to identify undervalued baseball players and compete with far better-funded teams. The core insight was that traditional scouting methods, which relied on gut instinct and conventional wisdom, often overlooked players who could contribute significant value. Instead, the A’s adopted a more analytical approach, using data to challenge biases and make more objective decisions.

This philosophy has clear parallels to early-stage investing, where conventional wisdom often drives decision-making. At RSCM, we take a Moneyball-style approach to identifying promising startups, favoring data and systematic analysis over gut feel and hype.

The Moneyball Principles Applied to Startups

1. Don’t Trust Your Gut Feel

One of the most famous lines from Moneyball comes from Beane himself: “Your gut makes mistakes and makes them all the time.” This applies just as much to investing in startups as it does to scouting baseball players. Research on gut feel (known academically as “expert clinical judgment”) consistently shows that expert intuition alone is unreliable. Statistical models built on substantial datasets outperform human judgment, even in fields like medicine and hiring.

The startup world often relies on unstructured interviews and subjective impressions, but these methods are notoriously poor predictors of long-term success. That’s why we focus on quantifiable factors and structured evaluation processes when assessing early-stage companies.

2. Use a “Player” Rating Algorithm (With Caveats)

In baseball, Moneyball relies on deep statistical analysis, drawing from thousands of recorded plate appearances per player. With startups, the data is far scarcer—most founders have very few “at-bats,” and startup outcomes are highly skewed, with the top 10% generating the vast majority of returns. This means that any attempt to create a founder “rating” algorithm will inherently be more limited.

That said, the Moneyball mindset is still valuable: rather than chasing the same overhyped, high-valuation deals as everyone else, we focus on finding undervalued opportunities. Conventional wisdom often favors founders with elite pedigrees, trendy sectors, and strong “social proof.” But those deals tend to be expensive. Instead, we seek a wide range of founders across diverse sectors and geographies, where valuations are more reasonable and potential upside is greater.

The Future of Moneyball for Startups

Even if you don’t predict massive outliers (“home runs”), a systematic approach can still yield strong returns. Our focus is on building a diversified portfolio of well-valued startups and letting the data work in our favor over time. At RSCM, we’ll keep refining our approach, looking for ways to better identify promising startups before the rest of the market catches on.

In a world where everyone chases the obvious winners, we’ll keep finding value where others aren’t looking. That’s the essence of Moneyball for tech startups.

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This post was originally published on 09/28/2011 and was last updated on 03/01/25.

People ike the idea of revolutionizing angel funding. Among the skeptical minority, there are several common objections. Perhaps the weakest is that individual angels can pick winners at the pre-seed stage.

Now, those who make this objection usually don't state it that bluntly. They might say that investors need technical expertise to evaluate the feasibility of a technology, or industry expertise to evaluate the likelihood of demand materializing, or business expertise to evaluate the evaluate the plausibility of the revenue model. But whatever the detailed form of the assertion, it is predicated upon angels possessing specialized knowledge that allows them to reliably predict the future success of pre-seed-stage companies in which they invest.

It should be no surprise to readers that I find this assertion hard to defend. Given the difficulty in principle of predicting the future state of a complex system given its initial state, one should produce very strong evidence to make such a claim and I haven't seen any from proponents of angels' abilities. Moreover, the general evidence of human's ability to predict these sorts of outcomes makes it unlikely for a person to have a significant degree of forecasting skill in this area.

First, there are simply too many random variables. Remember, startups at this stage typically don't have a finished product, significant customers, or even a well-defined market. It's not a stable institution by any means. Unless a lot of things go right, it will fall apart. Consider just a few of the major hurdles a pre-seed-stage startup must clear to succeed.

1. The team has to be able to work together effectively under difficult conditions for a long period of time. No insurmountable personality conflicts. No major divergences in vision. No adverse life events.
2. The fundamental idea has to work in the future technology ecology. No insurmountable technical barriers. No other startups with obviously superior approaches. No shifts in the landscape that undermine the infrastructure upon which it relies.
3. The first wave of employees must execute the initial plan. They must have the technical skills to follow developments in the technical ecology. They must avoid destructive interpersonal conflicts. They must have the right contacts to reach potential early adopters.
4. Demand must materialize. Early adopters in the near term must be willing to take a risk on an unproven solution. Broader customers in the mid-term must get enough benefit to overcome their tendency towards inaction. A repeatable sales model must emerge.
5. Expansion must occur. The company must close future rounds of funding. The professional executive team must work together effectively. Operations must scale up reasonably smoothly.

As you can see, I listed three example of minor hurdles associated with each major hurdle. This fan out would expand to 5-10 if I made a serious attempt at exhaustive lists. Then there are at least a dozen or so events associated with each minor hurdle, e.g., identifying and closing an individual hire. Moreover, most micro events occur repeatedly. Compound all the instances together and you have an unstable system bombarded by thousands of random events.

Enter Nassim Taleb.  In Chapter 11 of The Black Swan, he summarizes a famous calculation by mathematician Michael Berry: to predict the 56th impact among a set of billiard balls on a pool table, you need to take into account the the position of every single elementary particle in the universe.  Now, the people in a startup have substantially more degrees of freedom than billiard balls on a pool table and, as my list above illustrates, they participate in vastly more than 56 interactions over the early life of a startup. I think it's clear that there is too much uncertainty to make reliable predictions based on knowledge of a pre-seed-stage startup's current state.

"Wait!" you may be thinking, "Perhaps there are some higher level statistical patterns that angels can detect through experience." True. Of course, I've poured over the academic literature and haven't found any predictive models, let alone seen a real live angel use  one to evaluate a pre-seed stage startup. "Not so fast! " you say, "What if they are intuitively identifying the underlying patterns?" I suppose it's possible.  But most angels don't make enough investments to get a representative sample (1 per year on average).  Moreover, none of them that I know systematically track the startups they don't invest in to see if their decision making is biased towards false negatives. Even if there were a few angels who cleared the hundred mark and made a reasonable effort to keep track of successful companies they passed on, I'd still be leery.

You see, there's actually been a lot of research on just how bad human brains are at identifying and applying statistical patterns. Hastie and Dawes summarize the state of knowledge quite well in Sections 3.2-3.6 of Rational Choice in an Uncertain World. In over a hundred comparisons of human judgment to simple statistical models, humans have never won. Moreover, Dawes went one better. He actually generated random linear models that beat humans in all the subject areas he tried. No statistical mojo to determine optimal weights. Just fed in a priori reasonable predictor variables and a random guess at what their weights should be.

Without some sort of hard data amenable to objective analysis, subjective human judgment just isn't very good. And at the pre-seed stage, there is no hard data. The evidence seems clear. You are better off making a simple list of pluses and minuses than relying on a "gut feel".

The final line of defense I commonly encounter from people who think personal evaluations are important in making pre-seed investments goes something like, "Angels don't predict the success of the company, they evaluate the quality of the people. Good people will respond to uncertainty better and that's why the personal touch yields better results." Sorry, but again, the evidence is against it.

This statement is equivalent to saying that angels can tell how good a person will be at the job of being an entrepreneur. As it turns out, there is a mountain of evidence that unstructured interviews have little value in predicting job performance. See for example, "The Validity and Utility of Selection Methods in Personnel Psychology: Practical and Theoretical Implications of 85 Years of Research Findings" Once you have enough data to determine how smart someone is, performance on an unstructured interview explains very little additional variance in job performance. I would argue this finding is especially true for entrepreneurs where the job tasks aren't clearly defined. Moreover, given that there are so many other random factors involved in startup success than how good a job the founders do, I think it's hard to justify making interviews the limiting factor in how many investments you can make.

Why then are some people so insistent that personal evaluation is important?  Could we be missing something? Always a possibility, but I think the explanation here is simply the illusion of control fallacy. People think they can control random events like coin flips and dice rolls. Lest you think this is merely a laboratory curiosity, check out the abstract from this Fenton-O'Creev, et al study of financial traders. The higher their illusion of control scores, the lower their returns.

I'm always open to new evidence that angels have forecasting skill. But given the overwhelming general evidence against the possibility, it better be specific and conclusive.


This blog post originally published on 04/27/2009 by RSCM founder Kevin Dick and was last updated on 02/14/2025.

In science, there isn't really any such thing as a "fact".  Just different degrees of how strongly the evidence supports a theory. But diversification is about as close as we get. Closer even than evolution or gravity. In "fact", neither evolution or gravity would work if diversification didn't. But even so, RSCM's startup investing strategy puzzles some folks. They don't seem to truly believe in diversification. I can't tell if they believe it intellectually but not emotionally or rather they think there is some substantial uncertainty about whether it works. In either case, here's my attempt at making the truth of diversification viscerally clear.  It starts with a question:

Suppose I offered you a choice between the following two options:

(a) You give me $1M today and I give you $3M with certainty in 4 years.

(b) You give me $1M today and we roll a standard six-sided die.  If it comes up a 6, I give you $20M in 4 years. Otherwise, you lose the $1M.

Option (b) has a slightly higher expected value of $3.33M, but an 83.33% chance of total loss. Given the literature on risk preference and loss aversion (again, I highly recommend Kahneman's book as an introduction), I'm quite sure the vast majority of people will chose (a).  There may be some individuals, enterprises, or funds who are wealthy enough that a $1M loss doesn't bother them.  In those cases, I would restate the offer.  Instead of $1M, use $X where $X = 50% of total wealth. Faced with an 83.33% chance of losing 50% of their wealth, even the richest player will almost certainly chose (a).Moreover, if I took (a) off the table and offered (b) or nothing, I'm reasonably certain that almost everyone would choose nothing. There just aren't very many people willing to risk a substantial chance of losing half their wealth. On the other hand, if I walked up to people and credibly guaranteed I'd triple their money in 4 years, almost everyone with any spare wealth would jump at the deal.

Through diversification, you can turn option (b) into option (a).

This "trick" doesn't require fancy math.  I've seen people object to diversification because it relies on Modern Portfolio Theory or assumes rational actors.  Not true.  There is no fancy math and no questionable assumptions. In fact, any high school algebra student with a working knowledge of Excel can easily  demonstrate the results.

Avoiding Total Loss

‍Let's start with the goal of avoiding a total loss. As Kahneman and Tversky showed, people really don't like the prospect of losing large amounts. If you roll the die once, your chance of total loss is (5/6) = .83.  If you roll it twice, it's (5/6)^2 = .69.  Roll it ten times, it's (5/6)^10 = .16. The following graph shows how the chance of total loss rapidly approaches zero as the number of rolls increases.

By the time you get to 50 rolls, the chance of total loss is about 1 in 10,000.  By 100 rolls, it's about 1 in 100,000,000.  For comparison, the chance of being struck by lightning during those same four years is approximately 1 in 200,000 (based on the NOAA's estimate of an annual probability of 1 in 775,000).

‍Tripling Your Money

‍Avoiding a total loss is a great step, but our ultimate question is how close can you get to a guaranteed tripling of your money.  Luckily, there's an easy way to calculate the probability of getting at least a certain number of 6s using the Binomial Theorem (which has been understood for hundreds of years).  One of many online calculator's is here. I used the BINOMDIST function of Excel in my spreadsheet.

The next graph shows the probability of getting back at least 3x your money for different numbers of rolls.  The horizontal axis is logarithmic, with each tick representing 1/4 of a power of 10.

As you can see,  diversification can make tripling your money a near certainty. At 1,000 rolls, your probability of at least tripling up is 93%. And with that many rolls, Excel can't even calculate the probability of getting back less than your original investment. It's too small. At 10,000 rolls, the probability of less than tripling your money is 1 in 365,000.So if you have the opportunity to make legitimate high-risk, high-return investments, your first question should be how to diversify. All other concerns are very secondary.

Now, I will admit that this explanation is not the last word. Our model assumes independent, identical bets with zero transaction costs. If I have time and there's interest, I'll address these issues in future posts. But I'm not sweeping them under the rug. I'm truly not aware of any argument that their practical effect would be significant with regards to startup investments.

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This blog post was originally published on 05/02/2012 and was last updated on 02/01/2025.

One of RSCM’s advisors once told us, “I would think most smart people get RSCM’s philosophy intellectually, but many are stuck in the mindset that they have a particular talent to pick winners.” Another friend quipped, “VC seems to be a game of getting a reputation as a professional die thrower.”

Both of these statements resonate. But here’s the kicker: Even if you do believe in someone’s exceptional skill at rolling the dice, you may still be better off backing an unskilled roller. Diversification is that powerful.

The Dice Game: A Thought Experiment

Consider the following two investment options:

1. A diversified, systematic approach – You invest $1M today, and in four years, you receive somewhere between $3M and $3.67M with 99.99% certainty.
2. A concentrated bet on a “skilled” investor – You invest $1M today, and a professional rolls a six-sided die. If it lands on a 6, you get $20M in four years. But this investor is so skilled that they never roll a 1 or 2, effectively raising their chances of rolling a 6 to 25%.

Option 2 has an expected value of $5M, while Option 1 has an expected value of $3.33M. Mathematically, the professional has a 50% edge. But the problem? They still have a 75% chance of losing all your money.

If half their net worth were on the line, even the wealthiest investors would likely choose Option 1. Why? Because diversification smooths out uncertainty, even when a skilled player is involved.

The Power of Diversification in Practice

Let’s extend the dice analogy to illustrate how diversification changes the game. Suppose we analyze three types of rollers:

• Unskilled Roller: Rolls a 6 one out of six times (16.7%)
• Somewhat Skilled Roller: Avoids rolling a 1, rolling a 6 one out of five times (20%)
• Very Skilled Roller: Avoids rolling a 1 or 2, rolling a 6 one out of four times (25%)

Probability of Getting Your Money Back

• At a 90% confidence level, the unskilled roller needs 13 rolls to achieve a strong chance of breaking even.
• The somewhat skilled roller needs 11 rolls.
• The very skilled roller needs 8 rolls.

A skilled roller “saves” a few rolls, but even at a 97% confidence level, an unskilled roller making 20 rolls is vastly preferable to a skilled roller making just 2 rolls, despite the latter’s higher expected value per roll.

Probability of Achieving a 2.5x Return

• The somewhat skilled roller needs 2 to 5 fewer rolls than the unskilled roller to reach an 80% confidence level.
• The very skilled roller eventually dominates, but only after 30+ rolls.
• Even at 30 rolls, many investors would still prefer the 76% chance of achieving a 2.5x return from an unskilled roller over the 58% chance from a very skilled roller making just 3 rolls.

How This Applies to Startup Investing

1. Number of Investments – Research from Rob Wiltbank (AIPP data) found that the average angel investor holds 8-9 investments. That’s not nearly enough for true diversification. Our dice model suggests that 100+ investments are needed for reasonable confidence levels in startup returns.
2. Win Probability – In seed-stage, capital-efficient tech startups, the top 5% of outcomes account for 57% of total returns. This suggests that diversification is even more important than our dice model predicts.
3. Degree of Skill – While some angels might have an edge, it’s likely modest (maybe 20% at best). Seed investing is not an environment where expertise reliably translates into outperformance—just read chapters 21 and 22 of Thinking, Fast and Slow by Daniel Kahneman.

The Takeaway

Even if you believe you (or someone you know) has skill in picking early-stage investments, diversification should come first. Then, focus on scaling the application of skill within a broad portfolio.

And remember, just because someone has a few successful investments doesn’t mean they have the magic touch. With 422,350 active angels in the U.S., even if every angel made 10 investments, pure luck would generate thousands of investors with seemingly remarkable hit rates—while tens of thousands would have zero wins, also purely by chance.

Diversification isn’t just a hedge. It’s a strategy. And in seed-stage investing, it might be the most important one you have.

This blog post was originally published 05/12/2012 and it was last updated 12/20/2024.

For venture capital investors, Qualified Business Stock (QSBS) is one of the most lucrative tax benefits hiding in plain sight. It offers investors the chance to keep more of their returns by eliminating taxes on gains.

Despite being part of the U.S. Tax Code since 1993, QSBS was unused for decades—overshadowed by shifts in capital gains rates and overlooked by even seasoned investors. But today, thanks to key legislative changes, QSBS is making waves as a game-changer for venture funds, angel investors, and entrepreneurs alike.

In this post, we’ll explore the history and mechanics of QSBS, how it can transform your tax implications, and what you need to know to take advantage of it. If you’re investing in early-stage startups, this might just be the most important tax benefit you’re not fully using—yet.

QSBS first appeared in 1993, but was largely ignored

In 1993, Congress set out to incentivize investment into U.S. small businesses. As a result, Section 1202 of the IRS Tax Code was created as part of the Revenue Reconciliation Act of 1993. The goal was to give tax breaks to investors who purchased Qualified Small Business Stock (QSBS) and held it for more than five years. Initially, the tax break offered a blended tax rate of 14% on the first $10M of qualifying gains, or gains equal to 10 times the investor’s cost basis – whichever was higher. This was achieved by exempting 50% of the gains from taxes and taxing the remaining gains at a special rate of 28%.

At the time of Section 1202’s introduction, the maximum tax rate for long-term capital gains was 28%, making the effective 14% rate on QSBS gains highly attractive. However, very shortly afterwards, Congress reduced the maximum long-term capital gain tax rate to 20%, diminishing the relative impact of the QSBS benefit. By 2003, when the maximum long-term capital gains rate was further reduced to 15%, Section 1202 became virtually irrelevant. Saving 1% was not compelling enough to justify the extra complexity and tracking required.

The 2008 financial crisis sparked a QSBS revolution

The U.S. and global economies were plunged into a deep recession in late 2008 and 2009. In response, Congress incrementally expanded the QSBS tax break over the following years. Initially, these increases were temporary, lasting for short periods and sometimes applied retroactively. It wasn’t until 2015 that QSBS, as we know it today, became a permanent fixture of the U.S. Tax Code.

Key legislative changes included:

1. The American Recovery and Reinvestment Act of 2009: This act temporarily increased the tax-free exclusion from 50% to 75% for stock acquired after February 17, 2009.
2. The Small Business Jobs Act of 2010: It temporarily raised the tax-free exclusion to 100% for stock acquired after September 27, 2010, although only for a short period. This act also excluded QSBS gains from Alternative Minimum Tax (AMT) calculations.
3. The American Taxpayer Relief Act of 2012: This act retroactively reinstated the 100% tax-free exclusion and extended it forward for stock acquired through January 1, 2014.
4. The Protecting Americans from Tax Hikes (PATH) Act of 2015: This legislation permanently codified QSBS benefits, making qualifying gains 100% tax-free federally, exempt from AMT calculations, and free from the 3.8% Medicare tax. This was the true game-changer!

QSBS is now one of the best tax breaks in U.S. history

Today, QSBS stands out as one of the most impactful tax incentives in the history of the U.S. Tax Code. However, it wasn’t until the late 2010s and early 2020s that investors began to fully recognize the economic advantages of QSBS tax gains.

Here is the current tax treatment for qualifying QSBS gains:

• Tax-Free Federally: Gains are entirely excluded from federal income taxes.
• Exempt from Medicare Tax: The 3.8% Medicare tax does not apply.
• No Alternative Minimum Tax (AMT) Impact: QSBS gains are excluded from AMT calculations.
• State Tax Benefits: Gains are tax-free in 45 out of 50 states, with exceptions in Alabama, California, Mississippi, New Jersey, and Pennsylvania.

This combination of tax benefits makes QSBS an unparalleled opportunity for investors seeking to maximize their after-tax returns.

Holding Period Requirement

To be eligible for tax-free gains, Section 1202 requires that a taxpayer must hold QSBS stock for at least five years.

Limitations on QSBS gains

Section 1202 limits the amount of tax-free gain from any individual QSBS sale to the greater of $10M or 10 times the investor’s basis in the stock. Notably, this limitation applies on a per-company basis, not per taxpayer. As a result, an investor can claim up to $10M in tax-free gains for each eligible QSBS company they invest in, with no annual or lifetime cap on the total benefit.

What makes a company qualify for QSBS?

To qualify as a Qualified Small Business (QSB), a company must meet several criteria. While we won’t cover all the details here, the primary high-level requirements pertain to:

• Corporate structure: The company must be a U.S. C-corporation.
• Business activity: The company must actively conduct a “qualified trade or business.” (See definition below.)
• Asset limitation: The company must have less than $50M in aggregate gross assets immediately after the funding round in which the stock is purchased, as well as at all times prior.

What is a “qualified trade or business”?
The IRS defines it by exclusion, specifying what does not qualify. The following types of businesses are excluded:

• Businesses providing services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage, where the principal asset is the reputation or skill of one or more employees.
• Banking, insurance, financing, leasing, investing, or similar businesses.
• Farming businesses, including those involved in raising or harvesting trees.
• Businesses engaged in the production or extraction of resources for which deductions under Section 613 or 613A apply.
• Businesses operating hotels, motels, restaurants, or similar establishments.

Almost all other types of businesses qualify, meaning that the majority of U.S.-based tech startups structured as C-corporations (which is most of them) meet the criteria for Qualified Small Business status during the early years of their operations.

Can you get the QSBS tax break by investing in VC funds?

Yes. The QSBS tax benefit extends to partnerships or LLCs treated as passthrough entities for tax purposes. This means that investors in most early-stage VC funds are eligible for tax-free QSBS gains, provided the VC firm properly tracks these gains and reflects them as QSBS gains on the K-1 tax forms issued to investors each year.

In fact, a VC fund can generate well over $10M in QSBS gains from a single investment, and 100% of that gain can still pass through to its investors tax-free. This is because each individual investor in the fund has their own $10M QSBS limit per investment (as illustrated in Example 3 below).

QSBS tax benefit examples

Example 1:

An investor purchases QSBS in a qualifying company for $200k. After holding the stock for more than five years, they sell it for $5.4M, realizing a $4.4M gain. Under Section 1202 of the U.S. Tax Code, the entire $4.4M gain is tax-free federally. Additionally, the $4.4M gain is not subject to state tax in 45 of 50 states.

Example 2:

An investor purchases QSBS in a qualifying company for $1M. After holding the stock for more than five years, they sell the stock for $25M, realizing a $24M gain. In this instance, the investor exceeds the maximum $10M QSBS tax benefit. As a result, $10M of the gain is tax-free, while the remaining $14M gain is subject to long-term capital gains taxes.

Example 3:

An investor commits capital to a VC fund, which invests $1M in QSBS stock. More than five years later, the fund sells the stock for $30M, generating a $29M gain. How much of this $29M gain will investors receive tax-free? Surprisingly, it’s likely all $29M.

Here’s why: Each individual investor in the VC fund has their own $10M tax-free limit per investment. For example, if a single investor holds a 20% stake in the fund, the IRS treats them as having invested $200k in the company (20% of $1M) and as receiving $6M in liquidity (20% of $30M). This results in a $5.8M gain for that investor—well below the $10M cap—making the entire gain tax-free under QSBS.

But wait, there’s more: Investors can offset QSBS losses with Section 1244

Section 1244 is another lesser-known part of the U.S. Tax Code relevant to QSBS. It provides a unique benefit: If your investment is part of the first $1M invested in a QSBS company and the investment results in a loss, that loss can be deducted as an ordinary loss rather than a capital loss. In practical terms, this means the loss can offset ordinary income, providing a significant tax advantage.

Losses under Section 1244 are capped at $50,000 per year for individuals and $100,000 per year for married couples filing jointly.

Section 1244 has limited relevance in the traditional VC landscape since venture capital firms are rarely involved in the initial $1M invested in a company. Even Pre-Seed stage rounds typically exceed this threshold. However, individual angel investors and VC firms that focus on smaller funding rounds (such as ours) can benefit from this additional QSBS tax advantage.

How RSCM’s strategy benefits from QSBS

Although we didn’t initially design our strategy to take advantage of QSBS when we started our firm in 2012, it turns out that our focus aligns perfectly with the type of small funding rounds the government intended to incentivize. As a result, RSCM funds and investors have benefited greatly from the tax advantages provided under Sections 1202 and 1244 of the U.S. Tax Code. On average, we estimate that more than 80% of the gains from our funds will qualify as QSBS gains, and in some cases will exceed 90%. For example, over 90% of our Fund 1 distributions have been QSBS-eligible.  

When combined with the tax benefits from Section 1244 losses, the federal tax rate for most of our funds is expected to fall within the low-to-mid single digits.

QSBS: Encouraging innovation and benefitting investors

The U.S. government introduced the QSBS tax break to stimulate investment in U.S. startups and small businesses, recognizing the vital role these companies play in innovation, job creation and overall economic growth. By reducing the tax burden on successful investments, QSBS encourages more capital to flow into early-stage companies, helping to fuel entrepreneurship and economic progress.

Although it took years for QSBS to gain traction, it is now recognized within the small business and early-stage venture investment communities as a significant advantage. QSBS has come to fulfill its intended purpose, becoming a powerful tool for investors while supporting the broader goal of a dynamic and growing economy.
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This blog post is NOT professional tax advice

This blog exists to summarize the history and benefits of the QSBS tax breaks. It should NOT be construed as a complete or exhaustive overview, nor should it be considered tax advice. There are additional criteria not mentioned in this post that can disqualify a company and its investors from receiving QSBS tax benefits. Please consult a tax professional before making any personal investment decisions.

For pre-seed and seed stage startups, investor updates are a challenge. Often, founders try to make them too ornate and end up getting behind. Similarly, investors don't always have the time to fully digest a finely crafted narrative and lose track of what's happening. At RSCM, our portfolio of pre-seed and seed-stage investments is at about 2000 today, so we have lots of experience with updates. Not only do we read them all, we write a 3-7 line internal summary and each one goes into our CRM system so we have a complete history at our fingertips.In my opinion, useful investor updates have three requirements: they must get done, they must be easy to produce, and they must be easy to consume.

Anatomy of an Update

You can deliver on all three requirements by breaking updates into modules and putting the most important modules first. That way, you need only produce the modules you have time for and we need only consume the modules we have time for. Everybody wins.Here are the modules and order I recommend:

[Company Name] Investor Update for Month Ending [Last Day of Month]

• Metrics
• Highlights (Optional)
• Asks (Optional)
• Thank Yous (Optional)
• Commentary (Optional)

Notice that the only required module is "Metrics". This should be easy to produce because, at any given moment, you should have a handful of Key Performance Indicators (KPIs) you track anyway. This should be easy to consume because most investors have lots of experience absorbing tabular business data. This should be easy to get done because, in our modern software-driven world, KPIs are at your fingertips. Most importantly, if they are the metrics you are actually tracking to run your business, then they will be reasonably informative to investors. Requirements satisfied!More detail on metrics in a minute, but first some quick notes on Highlights, Asks, and Thank Yous. If you opt to include these modules, do them as bullets. Easier to produce and easier to consume. But, as with PowerPoint slides, no more than 7 bullets per section! Even then, only go to 7 on rare occasions. No more than 5 most of the time. It's easy for people to get saturated and when they get saturated, they flush the entire list from their attention. If you've got more to say, put it in the Commentary.Everything after Metrics really is optional. Better to get the update out the door quickly than wait until you come up with points for every section. If you ever find yourself thinking something like, "I'll crank out the Asks later," stop! Just hit send. Then if you do think of important items later, put them in a notes file and include them in the next update. Or send out a specific Asks email.

Universal Metrics

Now for some depth on metrics. There are really two types: (1) those that are universal to all pre-seed/seed startups and (2) those that are particular to your business. Investors need both. The first type gives us a general sense of how things are going for you relative to the typical startup lifecycle.  Kind of like the vital signs that all doctors want to know regardless of patient or condition.  They help us triage our attention. So start with them:

• Revenues: [revenues | date when you plan to start selling] (+/- ?% MoM)
• Total Expenses: [expenses] (+/- ?% MoM)
• Net Burn: [total revenues - total expenses] (+/- ?% MoM)
• Fundraising Status: [not raising | planning to raise | raising | raised]
• Fundraising Details: [how much, what structure, valuation/cap, who]
• Ending Cash: [last month's Ending Cash - this month's Net Burn + this month's Amount Raised] (+/- ?% MoM)
• Full Time Employees: [FTEs, including founders] (+/- # MoM)

Note 1: we strongly encourage a monthly update cycle. Anything longer means we get data that's too stale. Anything shorter, and the financial metrics don't really make sense. Though if you're part of an accelerator that encourages weekly updates, we'd love to see them. Just make sure we also get the monthly metrics!Note 2: always put the percentage or absolute month-over-month changes in parentheses next to each entry. It turns out that highlighting the deltas make updates dramatically easier for us to absorb by drawing immediate attention to the most volatile areas.A couple of quick explanations. Always have a Revenues line. If your product isn't finished or you aren't actively trying to generate revenues, just put the target date for when you do plan to start selling. Either piece of information is enormously helpful to us. Also, provide an FTE number that logically reflects the labor resources at your disposal. A full time contractor is a unit of full time labor that you can call on. Two half-time employees are also one unit. An intern may or may not be a unit or fraction of a unit depending on how much time he/she is putting in and whether the output is roughly equivalent to what a regular employee would produce. Don't exclude people based on technicalities, but don't pad your numbers either.Now, some detail about fundraising status. This topic turns out to be pretty important to existing investors. First, it lets us know that you're on top of your working capital needs. Second, some investors like to participate in future rounds and even the ones that don't are a great source of warm leads. Third, it makes us feel good to know that other people have or will be validating our previous investment. Here are a couple of example fundraising bullets:

• Fundraising Status: planning to raise in 4Q2015
• Fundraising Details: $750K - $1M Series Seed at a $5M-$6M pre-money from a small fund and/or local angels

• Fundraising Status: raising
• Fundraising Details: $300K - $500K on a convertible note at a $2.75M cap with $175K soft committed from [prominent angel name] and other local angels

• Fundraising Status: raised and raising
• Fundraising Details: $400K closed of a $600K convertible note at a $4M cap from [small fund name], [AngelList syndicate name], and local angels.

Custom Metrics

At any point in time, there should be a handful of top-level KPIs that you monitor to help run your particular startup. Of course, they vary across lifecycle stage, technology area, and business model. Just pick the most important 2-6 and give them to us. Feel free to change them as you pivot and mature.Here's an example for a pre-product enterprise SaaS company:

• Projected Alpha Delivery Date: 11/30/2015 (+15 days)
• Alpha Access Wait-list: 47 Companies (+8)

And one for an enterprise SaaS company that recently shipped private beta

• Max Queries/Minute: 1,201 (+29% MoM))
• Outstanding Critical Bugs: 3 (-2)
• Inbound Inquiries: 481 (-17% MoM)
• Qualified Prospects: 19 (+2)
• Paid Pilots: 3 (New Metric!)

And finally one for a consumer Web company in full operation

• Max Concurrent Users: 1,006 (+30% MoM)
• Registered Users: 23,657 (+13% MoM)
• Monthly Actives: 3,546 (+4.5% MoM)
• Users Making Purchases: 560 (+21% MoM)
• Total Purchase Value:$17,993 (+28% MoM)
• CAC: $12.55 (-7% MoM)

That's it. We estimate that, if you keep your accounting system up to date and use MailChimp, producing an update with metrics and a few extra bullets should take about 15 minutes (with some practice). And you'd be heroes in our book.  Well, all entrepreneurs are already heroes.  So you'd be superheroes!

This post originally published on 10/15/2015 and was last updated on 11/10/24.

People sometimes ask us, "What's the #1 mistake startup founders make?" Based on our 2000 pre-seed portfolio companies, one of the prime candidates is: "Planning for Series A."I don't mean the way you plan for Series A. I mean the fact that you do it at all. We see a lot of pre-seed pitch decks. A decent fraction have a "Comparables" section that list the Series A raises for companies with similar models in the same industry. In these cases,  Series A has become an explicit planning goal, despite the fact that these companies are at least two rounds, and probably three or four, away from that milestone. But the prevalence in pitch decks vastly understates the issue. From systematically interviewing 800+ founding teams in accelerators, it's clear that Series A expectations play a substantial role in most founders' planning.

While completely understandable, even considering Series A at the accelerator stage is usually a huge mistake. As I've written before, taking Series A at the point where it's appropriate decreases your success rate (though increases your expected value). Unsurprisingly, actually working backward from a future Series A can create all sorts of planning pathology. Yes, TechCrunch makes a big deal out of Series As. Yes, lot of cool VCs blog about Series A. Yes, VC investment leads to pretty fantastic story lines on "Silicon Valley". But these sources of information inherently screen for outliers. It's still the exception. Even among successful tech startups. Fundamentally, you're trying to engineer an extreme outcome in a highly uncertain environment. On first principles, this is problematic, as Nassim Taleb so beautifully explains the The Black Swan. But let's work through the steps.

Start with a modern Series A of roughly $10M as your goal. OK, those VCs will want evidence that you can quickly grow past the $100M valuation mark. That means you'll probably need about a $3M Series Seed 12-24 months beforehand to build the necessary R&D, sales, and customer success scaffolding, as well as prove out a huge addressable market. This in turn implies a $1M angel round coming out of an accelerator to complete the full-featured version of the product and establish a firm beachhead market over the next 12-18 months.

Now, I can tell you from reading the investor updates for 2000+ pre-seed startups that such rounds are very hard to raise... unless you're a strongly pedigreed founder, have obviously anti-gravity level technology, or have crazy traction in a hot space. We like to say rounds at this stage have a "geometric" difficulty curve. A round that is twice as large is four times as hard to raise.

Even if you manage to raise that round, the failure rate at each subsequent stage is high because you're continually striving to achieve outlier levels of growth. There's not much room for error or setbacks.  It's like trying to run up a ridge that just keeps getting steeper and narrower, with a sharp drop into the abyss on either side.

So what's the alternative? We recommend you ask yourself, "What's the smallest early acquisition (but not just acqui-hire) that I'd be satisfied with?" Unless you have a significant previous exit, are already very wealthy, or have unusual risk preferences, this number is likely somewhere between a $10M and $35M acquisition where the founders still own about 1/3 to 1/2 the company. Then work backwards from that.

Now, you may be saying to yourself, "Wait a minute! If I could get acquired for $10M to $35M, I could get a Series A. It's the same thing." Not exactly. $20M is a typical Series A pre-money these days, at least from a traditional name firm. But you would also need to be able to demonstrate that you could quickly grow to be worth $100M+. And you usually get a bit of a premium on acquisitions. So it's only at the upper end of the range where a Series A would be a fit, and then only some of the time.

Importantly, acquirers mostly want to see a great business or great technology and Series A investors mostly want to see enormous growth potential, which often aren't quite the same thing.

Finally, Series A investors usually want to see extremely rapid past growth, as an indicator of rapid future growth. Acquirers care much less how much time it took you.Also, the cost of being wrong is asymmetric. Say you aim for Series A from the outset. If at any point it doesn't work out, you either fold or do a fire sale. In a fire sale, liquidation preference will kick in and founders will get zilch anyway. Conversely, say you go the smaller route and things go much better than expected. You can still "upgrade" to the Series A path. And if you go the smaller route and fail, there's some chance you'd still make a modest amount in a fire sale or acqui'hire.

So now let's work backwards from the acquisition. We'll assume that revenues, rather than technology capability, is the relevant metric because it makes the reverse induction more clear cut.

1. In most tech sectors, a $10M to $35M acquisition means $1M to $3M per year in margin (not gross revenues, though in some sectors, the margins are so high, it's the same thing). That's low $100Ks of margin per month.
2. Next, we like to think in terms of the "straightforward scaling factor". This is the multiple by which you can grow with straightforward scaling of your product development and sales machines. No major overhauls of the product, no completely new channels, and no huge breakthroughs. Basically keep doing what you're doing, but with more resources. In most segments, this factor is 3-4X for a target in the $100K/month order of magnitude. Obviously, it's not a sure thing. Bad things can still happen. It can turn out that you've made a mistake. But it's the difference between needing circumstances not to go strongly against you and needing circumstance to go strongly for you. That works out to $20K to $80K per month, depending on scaling factor and target outcome. Thus, your near-term goal becomes, "Build a business doing $20K to $80K per month in margin."
3. If your minimum acceptable exit is on the higher end and your scaling factor is on the lower end, you might want to break this stage into two (though your might want to ask yourself why your minimum is higher given the lower scaling factor). In most cases, the first step therefore reduces to, "Build a business doing $20K to $40K per month in margin."

This is often a very achievable goal with a very modest amount of capital. How do you go about raising a round to support achieving this goal? Well, we have a post for that.

It's worth noting that, in terms of our expected returns, it doesn't matter too much to us one way or another whether founders follow this plan. Our funds have many hundreds of companies, so we're expected value decision makers. Though there is also some argument to be made for preserving option value by having companies survive longer. But it's not a huge difference either way at our level of diversification.

However, for founders who can only do a handful of startups in their career, understanding the difference between success probability and expected value could be literally life altering. And don't forget, once you have a modest exit under your belt, you've got the pedigree! So it's much easier to command the resources and attention necessary to go big from the start on the next one.

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This blog post originally published on 12/10/2020 and was last updated on 10/14/2024.

I see a lot of pitch decks. Hundreds per year. Almost every one is wrong. Not the startup idea. Not the slide layout. Not the facts per se. But which facts and in what order. Nearly all founders use a structure guaranteed to kill their “conversion rate”.

The common flaw stems from a fundamental mismatch in the way our brains create versus consume content. Each engages a different rms of reasoning. I studied this general topic in graduate school under one of the pioneers in the field. I kept up with the literature over the years. And I observed a huge number of pitches. But it still took me years to realize what was happening (repeating the same mistake in my own pitches, of course). Once I did, I couldn’t help appreciating the ironic beauty of the situation.

First, some background in cognitive psychology. Your brain has two completely different reasoning systems. System 1 is the fast, associative pattern-matching module—good for sitting in the background while you walk the plains and then rapidly determining whether a rustle in the bushes signifies mortal danger or a tasty dinner. System 2 is the slow, logical alternative-weighing module—good for deliberately figuring out whether it’s best to make camp by the river or on the hill. (If you want the full general audience explanation of System 1 and System 2, read Thinking Fast and Slow by Daniel Khaneman, who was the partner of my late professor, Amos Tversky.)

Now, when you build a pitch deck, you have to call on System 2 to develop the content. System 2 is logical so you can’t help but try to construct a deductive proof of why someone should invest in your company. That’s why most pitches have 3-7 slides setting the stage: here’s the problem, here’s the size of the problem, here are the current solutions, here are the drawbacks of current solutions, here are the requirements for a better solution…” I refer to this pattern as “In the Beginning”.

However, when investors consume that pitch deck, either at Demo Day, in an email, or face-to-face, they call on System 1. For most people in most situations, System 1 is the default. System 2 takes much more energy and operates much more slowly, so it only gets called on when something special happens. Thus, unless your pitch quickly triggers investors' System 1s to recognize your company as a tasty dinner, their System 2s will never wake up and no amount of logic can help you. And then when you use your System 2 to try and improve your pitch, you'll be blind to the problem.

You may be wondering why none of your advisers notice this problem when they reviewed your deck or watched a practice pitch? Here's another ironic bit. People who sincerely want to help with your pitch will expend the effort to use System 2, also blinding them to the lack of System 1 appeal.

Perhaps the worst case of “In the Beginning” I’ve seen was at a pitch event several years ago with a brutal schedule of 12 fifteen-minute slots. A company in the last hour really started at the beginning: the last generation of technology, quotes on recent shortcomings of that generation, market sizing for the next generation, the founders’ previous experience designing this type of system, technical architecture of their new solution, and performance metrics versus the primary incumbent. Logical, but not engaging. Ran over his time and had to rush through the last slide, which was something along the lines of logos for 5 blue chip enterprise customers, an average annual contract value of $60K/year, and current $MRR of $35K/month with 20% MoM growth for 6 months.

WTF? By the time that slide flashed on the screen, 80% of the audience members were fiddling with their cellphones or chatting with their neighbors. Talk about a missed opportunity! Better to just show that last slide, drop the mike, and walk off the stage!

Luckily, identifying the problem suggests an obvious solution—focus on triggering System 1 to flag you as interesting. So without further ado, here’s Kevin’s “Hey, tasty dinner right here!” pitch template:

• ^‍Title Slide
• Context Slide: super high-level explanation of what you do, 5 bullets max
• BOOM! Slide: the most impressive thing about your company
• Ask Slide: what the next BOOM will be and what you need to get there‍
• Why Slides: details on how you made the first boom happen and why you’ll make the next boom happen too

Putting the Ask right after the Boom is key. The Boom triggers alertness and primes for action. Then you’ve got to give the investors something to pursue. Otherwise, you may lose their interest. Also, telling them about good stuff that will happen in the future right after good stuff that has already happened in the past naturally gives your good-stuff-forecast more credibility. Your investment ask will seem maximally reasonable at this point.

You may wonder why you need the Why slides at all? Well, once you wake up System 2, it needs to eat too. But keep the Why section as small as possible. The more facts you present, the more chance that System 2 will find a strong objection and dismiss you so it can go back to sleep—remember, System 2 requires a lot of energy. The goal is to just satisfy System 2 and get to the next step in the process. where you can bring other cognitive mechanisms into action. Oh, and when delivering the Why, keep referring back to the Boom as much as possible to maintain alertness. For example: “[Supporting Evidence]… which is why X customer loves us so much and is paying us so much money.”

My guess is that most founders’ pitch decks already contains 80%+ of this content. It’s just in the wrong order and probably too much detail on Context and Why. The big question you probably have is, “What should my Boom be?” Sorry, no blanket advice here. It’s situation dependent. But guess what? By simplifying the problem to one question, we’ve made it amenable to A/B testing. If your Boom isn’t obvious, generate 3-7 alternatives and test them against several investors each. Also, if you can’t come up with a decent Boom, it might be a signal that you haven’t made enough progress to fundraise with much success. So your near term goal becomes to make something Boom-worthy happen.

That's my preliminary diagnosis and treatment. I’ve given this advice face-to-face to many startups over the past two years and have received a lot of positive feedback. But it’s an inherently limited sample. So if you read this post, try out the approach, and learn anything interesting (positive or negative), please drop me a line and let me know! Maybe someday we'll be able to develop a thoroughly researched system of Evidence Based Pitching (EBP).

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This post was originally published on 05/10/2016 and was last updated on 10/14/24.

Investor updates can feel like just another task on a founder’s endless to-do list, but they’re actually one of the most powerful tools in your startup toolkit. Done well, regular updates strengthen relationships with investors, unlock new opportunities, and ensure your company stays top-of-mind when it matters most. Done poorly—or not at all—they risk creating frustration or missing out on crucial help when you need it.

This post is your guide to writing updates that are not just sent but read, valued, and acted upon. From building a sustainable habit to crafting updates that inform and engage, we’ll cover the dos and don’ts to help you get the most out of every email.

Getting It Done

• Do Start Small. A lot of founders, riding a wave of initial enthusiasm, start off writing huge, detailed missives… for a couple of months. But few can keep up that pace while running a high growth business. Then, in their own minds, they’ve set the bar too high and struggle to meet those self-imposed expectations. Better to start with a small, core update. Build the habit. Add to it incrementally. Same advice as for starting an exercise program if you want to get long-term results.
• Don’t Let Perfect Be the Enemy of Adequate. Founders tend to be goal-oriented, and those goals tend to be big. Many seem to have a vision of the perfect update in their minds--capturing all the excitement, possibility, and heartache they’re experiencing. That’s a lot of pressure to put on yourself every month while staring at a blank page, especially with all the other demands on your time. Let yourself off the hook and come up with a very basic template you can fill out in 10-20 minutes (see our Minimum Viable Investor Updates post for ideas).
• Don’t Fall into a Shame Spiral. Often, it seems founders miss an update, then feel like the next one has to be even better. Which makes the chance of delivering it lower. Which means the next one has to make up for two missed updates. And so on. Again, let yourself off the hook. Offer a brief apology, go back to Step One, and Start Small.

Getting It Read

• Do Send as Email. Email is the least common denominator. All investors have it. Nearly all investors have evolved a system for organizing email that works for them. There are lots of tools for managing email lists. Don’t use Slack. Don’t try completely new platforms. Feel free to use other platforms in addition to email. But put your core updates in email. (We could provide detailed reasons why each alternative platform is inferior but they all essentially boil down to standard least common denominator platform arguments.)
• Don’t Put the Content in an Attachment. Honestly, I don’t understand why founders attach updates as PDF, Word, and PowerPoint. Sure, supplementary material is fine in those formats. But we receive a lot of updates where the founder has clearly written a specific update document and attached it as a file. Forcing the opening of a file just introduces friction and attachments break/slow some forms of searching. One founder said he felt it was more secure. As our founder Kevin Dick, a former security guy, puts it: “Uh, no.”
  Note: There is an exception here. If the choice is between not sending a useful update at all and sending a pre-existing file like a board deck or pitch deck traction slides, go ahead and send the file.
• Don’t Rely Solely an Online Service Like Reportedly. Anything that requires a login introduces friction. But it also causes particular problems where partners in a firm jointly help portfolio companies and/or have a process for actively synthesizing a view of each portfolio company’s state. You don’t want a process that makes it hard for multiple people at a firm to look out for you. If you really want to use something like Reportedly, perhaps to manage discussions, copy the body of the update into the email as well.
  Note: if you want to centralize your detailed financial reporting as part of your accounting system, that’s fine. Just link to it from your update emails.

Maximizing Usefulness

• Do Put Metrics Up Front. Most founders seem to think the metrics are the punchline, but they should be the preamble. First, for the same psychological reasons that you want to put your traction up front in a pitch deck, as we explained in Your Pitch Deck is Wrong. Second, purely from a practical standpoint, if an investor is short on time, the metrics give the most information. Third, the metrics provide useful context for absorbing all the other information. Traffic shot up? I’m looking forward to finding out why. Burn spiked? I’ll expect an explanation. CAC and LTV both went up? This should be interesting.
• Do Include Financial Metrics. Financial metrics are your startup’s basic vital signs, like pulse and blood pressure. It’s really hard to maintain situational awareness of how things are going without them. Always provide Net Burn and Ending Cash. If you’re generating revenues, provide revenues. Better yet, break it down as applicable: recurring vs one time; COGs vs margin, inbound vs outbound, etc. Whatever is most relevant to your current situation. But please don’t use non-standard or ambiguous terms without defining them. If you’re not generating revenues, provide some indication of what the timeline is, whether it’s a target shipping date for revenue generating product, details of where prospective customers are in the pipeline, etc.
  Note: some founders think that financial metrics should be confidential. Not from people who gave you money! If there are people on your update list who are not investors and you don’t want them to know, split the distributions. If this sounds like a hassle, go to Step One and Start Small.
• Never Just Provide a Percentage Change. Perhaps even more frustrating than no financial metrics at all is seeing just a percentage change. Again, the motivation here seems to be confidentiality, but the same response applies. Statements like, “User acquisition costs dropped by 30% last month,” or, “Revenue rose 30% last month” are not only useless to your investors, they are extremely frustrating. The goal of your update is probably not to frustrate your investors.
• Do Provide Values as Well as Graphs. Graphs are great! But often the graphs will have weird scales or multiple scales or be generally hard to read. So if you graph a quantity, be sure that each point is either clearly labeled with the corresponding value or also put the values for the most recent period in text below the graph.
• Do Provide Fundraising Details. Investors can often help with fundraising. If not this round, then maybe the next one. We also like to get validation that our previous investment is appreciating! So knowing exactly where you are in a raise or where you ended at close is important. If you’re raising, report the target amount, the target valuation (a range is fine), how much you have committed, how much closed, and from whom. If you’ve completed a raise, report the final total, final terms, and final participants. And again, don’t use non-standard or ambiguous terms like, “We secured $500K from [firm].” What does that mean? A verbal promise, a written commitment, signed investment documents, a check?
• Do Organize Content into Digestible Chunks. Paragraphs of unbroken prose or lists of unbroken bullet points are hard to digest. Use descriptive and logical headings to group related information together. Never have more than three consecutive paragraphs of prose--and only then if the paragraphs are reasonably short. Never have more than seven consecutive bullet points. Only have more than three consecutive graphs if they’re all closely related and seeing them together is necessary to provide a coherent picture. For reference, here are the sections we use in our internal app for summarizing company updates: Metrics, Fundraising, Team, Business Model, Product/Engineering, Customers/Sales/Channel, Miscellaneous

What Investors Need from Your Updates

You may have specific circumstances not addressed by this list. In general, it helps to have a model of what your investors are looking to get out of the updates. First, remember that they are looking at your company mostly from the outside and can’t possibly have all the context you have, and there’s no way you can load it into their heads in a reasonable period of time. Second, investors want to be helpful if possible. But you don’t necessarily know if you need help or the best way each investor could help. Experienced investors actually have more context than you on how startups in general develop and the challenges they encounter. They obviously have more context about their own capabilities. So the best path is to give them a high-level and reasonably transparent view that both maintains consistency over time but also notes “inflection points” when you think you hit them. You should always feel free to ask investors what they want to see.

The Power of Staying Top of Mind

The absolutely most important thing is to send out an update regularly. Your investors and their extended networks are a valuable asset--but only if they are up-to-date on your company. If you have six investors, and they each give you just a single strategic introduction every other year, that’s three extra opportunities per year for good things to happen. You could be missing out on introductions to acquirers, channel partners, next-round funders, experienced potential hires, relevant advice, and much more. All because your investors don’t know what’s going on with your business. Can you really afford not to put this free upside in play?

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This post originally published on 08/07/2018 and was last updated on 8/10/24.

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The venture market bottomed out from historic highs last year. Total deal volume slumped roughly 50% from 2021’s peak, exit activity hit a ten-year low, and venture fund performance dropped across the industry. These rapid changes have created a new landscape for venture capital, and it’s affected how VCs are investing.

Right Side Capital surveyed 110 Pre-Seed and Seed VCs from February 2024 to May 2024 on their investment activity and strategies in 2023 and their plans for 2024, with a focus on Pre-Seed Rounds and Seed Rounds. VCs revealed that they are optimistic about the funding landscape in 2024 and that they have high expectations for revenue levels and growth rates from portfolio companies.

Below we share what we learned.

VCs Were Active in Pre-Seed Rounds in 2023

Surveyed VCs revealed that they were fairly active in Pre-Seed investment last year. Of the VCs surveyed, 87.0% made at least one investment in round sizes of $1M to $2.5M, and 35.2% made more than five investments at this stage.

Seed Round Deal Volume Was Less Than Pre-Seed Round Deal Volume in 2023

VCs reported less deal volume in Seed Rounds in 2023 as compared to Pre-Seed Rounds during the same period. Only 12.1% of surveyed VCs made more than five investments at this stage, and 25.9% made no investments at all. The majority (62.0%) made between one and four investments at this stage.

Investment Outlook Is Optimistic in 2024

Nearly half (45.4%) of respondents plan to make five to nine new investments in 2024, which is a significant increase from 2023, and 24.1% said they planned to make 10 or more investments this year. All respondents planned to make at least one investment, which indicates a more positive outlook from 2023.

Pre-Seed Fundraising: What VCs Expect from Founders in 2024

At the Pre-Seed fundraising stage, only 46.3% of surveyed VCs will invest in a pre-revenue startup, 27.4% will invest in a startup with sub-$150K annual recurring revenue (ARR), and 14.7% require $150K – $499K in ARR. For some surveyed VCs, revenue expectations can be even higher: 11.7% said they required startups to have $500K or more in ARR.

Growth expectations are high for Pre-Seed Rounds, with 34.8% of surveyed VCs expecting startups to double year over year at this stage, and 37% expecting startups to triple year over year.

Seed Fundraising: What VCs Expect from Founders in 2024

Expectations vary a lot for startups raising their seed rounds. At this stage, 17% of surveyed VCs will invest at pre-revenue, but 24% want to see ARR of $1M or more. That’s a big change from four years ago, when $1M or more in ARR was the criteria for Series A funding.

Surveyed VCs expect aggressive growth at this stage, with 47% investing in startups that are doubling year over year and 34% investing in startups that are tripling year over year.

Most VCs Recommend 6-12 Months of Runway

The majority (53.7%) of surveyed VCs advise their portfolio companies to maintain six to twelve months of runway before raising their next round. Only 29.6% of VCs advise startups to have over 18 months of runway.

Capital Efficiency Is More Important Than Ever

VCs reported that, in this leaner landscape, they are placing a greater emphasis on capital efficiency for portfolio companies. For 81.5% of respondents, capital efficiency is more important than ever before. The survey included an option for respondents to indicate that capital efficiency was unimportant, but not a single respondent selected it.

Roughly One Third of VCs Have Changed Their Investment Thesis

We asked respondents to write in answers about how their firm’s investment thesis has changed in 2024. Below we break down the results of those write-in answers.

Summary of Investment Thesis Changes in 2024

No Change (58%) The majority respondents indicated that their investment thesis has not changed significantly from 2023.

More Focus on Specific Areas (15%) Some VCs have an increased focus on specific sectors such as health, cyber, AI, and cybersecurity. They’re putting a greater emphasis on software, particularly AI-powered applications, and avoiding certain sectors like consumer and hardware.

“Like everyone else, [we have] more interest in AI-powered applications.”

– Survey respondent

Adjustments in Investment Strategy (10%) Some VCs are shifting to smaller check sizes. They indicated more capital allocation for Pre-Seed and they are rightsizing investment amounts to achieve more significant ownership.

Greater Sensitivity to Valuations and Due Diligence (7%) VCs are more sensitive to valuations, ensuring companies have more runway, and conducting more thorough due diligence. They’re also focusing on financing risk, revenue, traction KPIs, and efficient use of capital.

“[We’re] thinking more about financing risk and making sure companies have more runway.”

– Survey respondent

Increased Sector Preferences and Deal Dynamics (5%) A small subset of VCs have a growing preference for companies with experienced founders, significant revenue, and efficient burn rates. They’re avoiding overinvested spaces like sales-enablement software and sectors that are seen as high risk for next-round funding.

“[We’re] rarely taking pre-product risk unless the team has prior operating experience.”

– Survey respondent

No Specific Answer or N/A (5%) Some responses were “N/A” or did not specify a change in investment thesis.

Final Conclusions from the RSCM 2024 VC Survey

The venture capital landscape in 2024 has adapted to a leaner and more cautious environment. Right Side Capital’s survey reveals a higher bar for revenue expectations and a greater emphasis on capital efficiency than in more bullish periods.

Despite the challenges of 2023, VCs are optimistic about 2024 and plan to increase new investment volume. Overall, VCs are adopting a resilient and forward-looking approach, emphasizing sustainability and capital efficiency to navigate the transformed economic landscape.

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Founding a company is challenging enough without also heading your sales process. But Kelvin Johnson, the CEO and co-founder of Brevity, believes that leading sales is an opportunity for founders to get to know their customers. He’s developed a five-step sales process that tailors to a prospect’s pain points and adapts to his customer’s needs, while also allowing him to learn his Ideal Customer Profile (ICP) and build trust.

In a recent webinar for Right Side Capital Managment’s portfolio companies, Kelvin sat down with RSCM’s “Sales Doctor” Paul Swiencicki to share how he’s used his founder-led sales process to drive $600K in annual recurring revenue (ARR) for Brevity’s core product, an AI-powered sales role playing tool.

Below, we outline Kelvin’s sales process and highlight some of his key insights.

Step One: The Qualification Call

Kelvin uses a qualification call to kick off his relationship with a prospect to determine if his product will be a good fit for them. He makes sure the call takes place before any additional time is spent on the sales process. “We start off these conversations by asking, ‘What piqued your interest to even take this call?’ and ‘What will a successful outcome look like at the end of our 30 minute conversation?’ So at least we have an anchor point as to what’s important to them,” says Kelvin. “We may have our own agenda, but I really want to figure out what is important to this prospect. And I want to make sure we maximize our time.”

Qualifying leads is a critical part of sales success. A founder’s time is best spent on  prospects where their product can make a big impact. “At first, we weren’t doing a great job of qualifying our leads. But over time, we ended up discovering that our best ICP is somebody that’s at the sales manager level or above, who oversees at minimum 10 sales reps. That’s where it starts to make sense for us,” says Kelvin. “You’ve got to qualify hard to close easy.”

Step Two: The Custom Test Drive Demo

Kelvin has learned that a demo is much more effective when he caters to a prospect’s specific pain points. He schedules a “call before the call” in advance of a demo to gather information. “In the call before the call, we’re trying to figure out where a prospect is experiencing the greatest friction, what initiatives they have in place to alleviate that friction, and what have been the results of those initiatives,” says Kelvin. “We’re also trying to get into the weeds of what key success metrics matter the most to them, a.k.a., ‘How do you plan to justify this investment internally?’”

Once he knows what’s important to his prospect, he can give them a customized demo. Demonstrating he paid attention is also a great way to build trust and strengthen his relationship with the prospect. “You have to shut up, listen, and then here’s the most important part: As soon as you hear what the customer says, that’s the only thing you demo,” says Paul. “What I find is that everyone just does a spray and pray demo. It’s all just one size fits all. That’s not what prospects want. The first thing you have to demo is what they said their problem is. Otherwise, they’re not going to listen.”

Step Three: The Business Justification Review

After the demo, Kelvin sends the stakeholders a document that captures everything he’s learned about them thus far. The document outlines their problem, what they’ve already tried, the outcomes and results of those past solutions, what they stand to gain by using Kelvin’s product and, most importantly, what they stand to lose if they do nothing. “One of the most important sections in the document is about the cost of inaction – the lost revenue calculator,” says Kelvin. “The biggest thing we’re all competing with is doing nothing.”

He then schedules a call to go over the document with the stakeholders, so he can put all of the relevant information in front of the prospect in one tidy package. “This makes our champions look so good when they present to their CFO along with a supporting Excel sheet that shows them the cost of doing nothing, of not buying our product. That shows them why they need to start now,” says Kelvin.

Step Four: The Kick-Off Call

Kelvin is thinking about retention before he’s even closed the deal, which ultimately leads to higher ARR. Research has shown that retaining customers is cheaper than acquiring new ones and that improving retention by just 5% can drive profits up over 25%.

Kelvin sends the prospect a plan for implementation that sets expectations and shows clear milestones and goals. “We understand how overwhelming new software can be,” says Kelvin. “I’m trying to break it down into very digestible pieces.” He asks his new customer two questions: “Before the end of our renewal process, what are you going to brag to your board about?” and “What is one high-impact scenario where we can deliver first value?” Kelvin and his team can then have a kickoff call that caters to these primary objectives.

Step Five: The First Value Check-In

About one month after closing the deal, Kelvin schedules a call with his new customer to ensure they’ve hit their initial goal. “Our average customer is getting to first value within 17 days. Not because they’re focusing on uploading their entire sales playbook into our roleplaying software. No, no, no. We’re focusing on one high impact, high stakes, high frequency scenario,” says Kelvin.

From there, Kelvin can work with the customer to expand Brevity’s usage and ensure the customer is getting what they need. “I tell them, ‘It’s our job to make this simplified for you and your team,’” says Kelvin. “Everybody learns how to maximize the utility of the software within the first month. And then once we’ve nailed that, then we get to show ongoing value.”

A Repeatable Process for Building Revenue and Trust

Kelvin’s five-step sales process is a testament to the power of personalized engagement. It emphasizes active listening, customized demonstrations, and transparent communication that not only fosters trust but also ensures alignment between Brevity’s solution and the customer’s needs. By implementing Kelvin’s strategies, you can not only increase your chances of closing deals but also establish credibility, laying a solid foundation for a long-term, successful partnership.

Want to get more expert advice for your startup? Apply for funding from Right Side Capital to gain access to take part in our community of 1800+ founders and gain access to a host of free services including go-to-market, sales, marketing and fundraising advisory.

About Right Side Capital

Right Side Capital is one of the most active VC firms investing in the Pre-VC stage, partnering with 100+ capital efficient tech companies in the USA & Canada every year at an average round size of <$500K.

As a team of former founders and operators, we know that founders tackle problems that are equal parts challenging and inspiring. Building on our 12 years of experience with 1800+ portfolio companies, we’re changing how early stage startups receive funding and support.

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RSCM is different from the vast majority of startup investors.

We are one of the only ones that is completely transparent on our Web site about our criteria and completely open access to any founders that think they meet them. Then we are fast. We make decisions in days and fund in weeks.

If you’re familiar with how other investors work, you might find our behavior confusing. But once you understand our perspective, you’ll hopefully appreciate the rationality of our approach.

We look at the investment process like engineers:

• There are very large numbers of both startups and investors.
• The probability of any particular startup and any particular investor overlapping in their requirements is small.
• Startups and investors both want to find the best match.
• Time is valuable.

Conclusion: as an investor, (1) you want to be very up front with your target profile so startups outside this target don’t waste their time with you and (2) if you’re going to pass on a deal, you want to do so as quickly as possible. The later in the process you pass, the higher the cost to you and the startup. If you fail a high percentage of deals near the finish line, you’re doing it wrong.

When we analyzed and observed other investors, it seemed like two large sources of rejection frequently occurred at the very end of the process: outside of scope and disagreement on valuation. Investors would spend an enormous amount of time learning about a startup’s technology, business, and team, only to say, “No,” because they didn’t feel the investment ultimately matched their thesis or the founders wanted too high of a valuation.

Ideal Profile

To address the first category of failure, we made a list that defined our ideal profile and stuck to it. That may sound simple in theory, but it turns out to be extremely difficult in practice due to “fear of missing out”. Our goal was to come up with a set of criteria so crisp that we would never invest outside its boundaries and would invest in anything within its boundaries at the right price. Obviously, such perfection is impossible, but we are far closer to this ideal than everyone else.

Our list is not very long:

1. Must be a “technology startup”.
2. Must be “capital efficient”.
3. Must be looking for an investment of no more than our maximum round size.
4. Must be looking for a valuation of no more than our maximum valuation.
5. Must be located within our investment geography.
6. Must not be in one of our excluded business areas.
7. Must meet our minimum traction bar.
8. Must have a minimum number of FT founders..

Obviously, the parameters of each requirement can evolve. But it’s easy to declare them at any point in time, at least for (3)-(8).

Defining a “technology startup” is more subtle. For example, Internet auction sites and bookselling sites were “technology” in 1995. In the 2020s, not so much. What about a company that makes clothing from advanced materials manufactured by someone else and then sells it on Amazon? We would look at this business and conclude that their value add is the design of the clothing, so it’s fashion not technology. A similar analysis applies to resellers, who may sell extremely technical products, but their specific value-add is not the technology in those products.

Then there’s the issue of “technology-enabled” businesses–ones that apply technology internally to deliver a non-technology product such as car repair or temporary workers. In these cases, we consider how much technical advancement the startup has achieved and whether its business is likely to scale dramatically better than it would without the technology enablement. For example, if the technology enablement were superficial and easy to imitate, we would be a no. If the business required building or customizing specialty facilities at scale, also a no. If the differentiation were branding or fashion, no.

In general, we try to predict whether the business would scale rapidly due to its technological advantage and whether the exit market would treat the business as technology, with its associated high valuation multiples. Obviously, these touchstones are imprecise, but at least they provide a framework for making a determination.

The definition for “capital efficient” is also fuzzy. The underlying issue is that, the more capital a company needs to prove out its business, the more vulnerable it is. Also, when you’re an early investor that doesn't follow on, there can be structural challenges with large subsequent rounds that occur before a company has achieved product-market fit. The question we ask ourselves is, “Could this business reasonably get to breakeven, if necessary, with only $1M to $2M in total investment?” That doesn’t mean we don’t want companies to take more money; we just want them to have the choice and negotiating power of not needing large future rounds.

Valuation Up Front

Addressing the second challenge of avoiding mismatched valuation expectations is trickier. Any solution requires calculating at least a narrow range for the acceptable valuation up-front and at low cost. Initially, we developed a basic algorithm using parameters like founder experience and stage of technical development. This algorithm worked well enough to make us far more nimble than other investors, but required substantial qualitative judgment to determine the input value for each parameter. 

Then, a few years after we started investing, startups in our price range started routinely having initial revenues. We quickly realized that we could key valuations off these revenues. While more objective than our first algorithm, this path presented two sub-challenges.

The first sub-challenge was determining whether focusing on revenues would produce “negative selection”. It’s theoretically possible that the startups with the most potential to have very high returns are those working on groundbreaking products that take longer to reach a salable stage. In fact, there was also some conventional wisdom to this effect. However, there was also conventional wisdom from the “Lean Startup” movement that advocated getting some version of the product into the hands of customers as soon as possible.

When we analyzed our portfolio up to that point, we determined that several factors argued strongly for early revenues being a net positive:

• Burn. Startups at our stage seemed to typically burn $10K to $20K per month. Revenues of even $5K per month could extend runway 33% to 100%. Because we fundamentally believe that the earliest startups represent option value, revenue that extended runway should increase this value.
• Business. Having some customers willing to pay something is a positive sign that the startup is in a general area that might be a good business. Also, founders that are able to convince people to pay now is some indication that they’ll be able to convince people to pay more in the future. Finally, achieving initial revenue quickly and at relatively low cost is a signal of capital efficiency.
• Innovation. Having customers to test new features on and ask about broader needs is a valuable source of insight. People who pay money are a more reliable source of opinion because they have skin in the game.

The second sub-challenge was how to deal with different revenue models. Obviously, a company that sells a piece of hardware at 50% margin and then a bunch of professional services is quite different from a SaaS company with customers on annual contracts at 90% margin. After reviewing our portfolio to that point, we were able to construct a set of rules that accounted for these differences:

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1. Only revenues from the technology product or service count. No professional services revenues.

1. Only gross margins count. 
2. Growth path matters. A startup that reaches $10K/month in three months since launch is more attractive than one who took a year to grow from $1K to $10K.
3. Recurring matters. Customers on annual contracts are better than ones on month to month contracts, which in turn are better than those who pay once. Generating revenues from a spot market, such as an ad or affiliate network, is the least attractive.
4. Price point matters. At low price points, the sales channel must be very scalable and the acquisition costs pretty low. At higher price points, there is more room for error.
5. Sales channel matters. The lower cost and more scalable the channel, the better.
6. Acquisition cost matters. The less it costs to acquire a given amount of revenue, the better.
7. Revenue concentration matters. Having more than one enterprise customer or customer segment is more attractive.

With these rules, we can look at a startup’s revenues in the context of our historical deal flow and determine our valuation tolerance. Obviously, if we happen to have several recent deals with identical revenue characteristics, we can determine the valuation easily. But the above rules also allow us to make tradeoffs versus recent deals with different characteristics. For example, a company that is otherwise similar at half the price point would be worth a modest amount less. But if it had achieved revenue more quickly then grown much faster, that could make up the difference. In practice, we seem to be able to make these tradeoffs for most startups we encounter.

Importantly, we distinguish between the “market” price and the price we are willing to pay. While we may determine that the market price for a startup is X, that price is based on the startup going through the much lengthier, haphazard, and opaque process other investors use. So we typically ask for a price that is 20-30% below market. Conversely, we acknowledge that startups can likely get a 20-30% higher price if they are willing to go through that longer haphazard process. Note that this position makes us a more competitive choice for startups that don’t have a lead investor or a substantial fraction of the round closed. Startups that already have a chunk of working capital coming in obviously don’t get as much benefit from us moving quickly.

Logical Process

These two innovations, sticking to an ideal profile and aligning valuation expectations up front, lead to a straightforward, efficient investment process. We simply apply the concept of failing as fast as possible.

1. Receive request. We funnel all funding requests through our Web site to ensure we get a relatively consistent set of information that we can process quickly. Sometimes, we receive an electronic or verbal inquiry where we can “look ahead” to identify an obvious mismatch and save a founder the trouble of going to the site.
2. Screen for profile fit. Based on a company’s description, Web site, and deck, we try to determine if a company fits our ideal profile. Occasionally, making this determination may require a few emails.
3. Screen for valuation fit. Based on a company’s revenue model, current revenue level (including firm contracts going active soon), and capitalization structure, we calculate our valuation tolerance. Sometimes, making this determination may require a few emails. 
4. Make an estimated offer. If a company’s valuation expectations are far outside our tolerance, we often reject the deal out of hand. If there’s potentially some room for overlap, we will provide our estimated offer to the company. Sometimes, exploring whether there is overlap may require a few emails.
5. Review initial diligence documents. If there’s a profile fit and valuation alignment, we’ll review an initial set of diligence documents. We usually want to see a capitalization table, current balance sheet, monthly P&L spreadsheet, and some breakdown of customers.
6. Phone call. If the documents don’t present any red flags, we schedule a phone call to review the business in general and dig down on specific issues. Often we proactively schedule a phone call for a few days after the company’s estimated date for delivering the documents.
7. Make confirmed offer. Within 2 business days of the phone call, we make a confirmed offer or final rejection. We almost always make our offer based on a YC post-money SAFE with a cap set to our pre-money valuation plus the round size and a discount of 20%. In cases where there is a specific reason to use a different type of instrument, we can be flexible.
8. Final diligence. If the company accepts our offer, we proceed to final diligence. Unlike some investors, final diligence is not about figuring out whether there’s a good fit. Rather, it’s about verifying the information previously provided, as well as generally making sure the company is legally and financially squared away.
9. Execute investment. Once final diligence is complete, we generate investment documents, execute them, and then wire.

Typically, steps 1-4 take hours to days. The whole process requires 3-4 weeks from first contact to wire–if the company is responsive, has the necessary documents at hand, and there are no scheduling issues. 2 weeks is sometimes possible. The most common causes of delays are the company not having all the necessary initial and final diligence documents or there being some sort of circumstance that needs correction before we can proceed, such as converting to a C corporation. 

We often see other investors taking 3-4 months, sometimes longer, even in the good case. Moreover, we often see those investors saying, “No,” several months in. 

Internally, because our process always has a well-defined next step with a well-defined decision making scope, we rarely find ourselves getting bogged down. If we do, or if we end up having to say, “No,” late, we try to identify the underlying cause and fix it if possible.

Given this approach, we’ve found that it helps for founders to keep the following in mind:

• Meetings are late in our process. Just because we don’t take a meeting early, doesn’t mean we’re not seriously evaluating an opportunity. Scheduling introduces calendar delays and limits the number of startups we can work with at any one time. Luckily, we can collect the vast majority of information we need for a decision without a meeting. When we take a meeting (usually by Zoom), you have already checked off many of our boxes and we have concluded a fit is likely. 
• We care about the details of your revenues and unit economics. Because revenue is our number one metric, we tend to dig pretty deeply into the details of each revenue stream and its associated economics. We’re essentially trying to build a model of how your business generates gross margin.
• We care less directly about your vision and team. Other investors will often spend a lot of time trying to assess your vision and entrepreneurial spirit over several meetings. While we do care about vision and team, we are humble about our ability to assess them just by talking to you, so let the early results mostly speak for themselves.
• The more organized you are, the faster the process will go. However, we are patient. If, for whatever reason, you don’t have everything nicely organized, it usually won’t stop the deal. With a well-defined process, we can hold an investment at any stage while issues get resolved. In fact, we often help companies overcome obstacles during the process. But we would sincerely prefer to complete the process as quickly as possible so founders can start putting our investment to work in their businesses!
• We care about speed. We want to be fast so you can be fast. First, we want to get you back to the business of building your business. Then, once we’ve invested, we want you to have the resources for faster sales, marketing, and future fundraising.

In general, we see ourselves as less judgemental and more process driven than other investors. The goal is not to holistically assess each company and pronounce it a “good deal” or not. Rather, the goal is to systematically build a large portfolio of companies in a very specific area of the market. Just because a company isn’t in our target area doesn’t mean we don’t think it will succeed.